Difference between provision and reserve.

Banking & FinanceCompanies/OrganisationsManagement

Provisions are used in financial accounting to set aside funds to provide for a future excepted loss/liability. It is compulsory for companies to make Provisions to meet their future expenses. Reserves, on the other hand, are the surplus funds that a company sets aside in order to invest in future projects. Read through this article to find out more how Provisions and Reserves are used in Financial Accounting.

What is Provisioning in Accounting?

A Provision is the amount which kept aside to cover future expenses. It is a separate fund which is kept aside to cover certain expenses. Note that a provision is not a reserve. Examples of Provisioning include Guarantees, Deferred tax, Restructuring liabilities, Depreciation, Sales allowances, etc

A provision can be recognised if it meets the following criteria −

  • An entity which has a current obligation due to past events.
  • It may be cash outflow to settle obligation.

The main objective of provisioning is to make the balance sheet more accurate in an accounting period or financial year. Accountants use provisioning to present correct financial statements, predict losses and liabilities, and meet known losses and liabilities.

Companies do tax provisions to meet their income tax requirements. Tax deductions include depreciation, allowances, interest expenses etc. After some calculations, the firm determines its amount to be allocated on its books in a provision known as tax provisions.

What is Balance Sheet Reserve?

Reserves in the balance sheet are surplus funds that a company sets aside to carry out its future projects. Balance Sheet Reserves are of two types −

  • Capital Reserve − The capital reserve is funded by capital profits, which are typically not distributed as dividends to shareholders. It cannot be established from earnings generated by a company's main operations.

  • Revenue Reserve − Revenue reserves are derived from earnings generated by an organization's core operations. Revenue Reserves are recorded in the Reserves and Surplus portion of a balance sheet's liabilities section. It can be used to pay out dividends to shareholders or to expand the company in the future.

When companies make a sizeable profit, they retain a portion of it to meet future needs, growth prospects, and so on. In accounting, Reserves refer to the amount of money that is set aside for future. Reserves are helpful in strengthening an enterprise's financial condition and can be used for a variety of purposes including steady dividend payments, business expansion, meeting probable contingencies, legal requirements, investments, and improving overall financial health of a company.

For insurance companies, it is mandatory to show Reserves in their balance sheet. They show it in the liabilities side of their balance sheet as the Reserves set aside for settling future insurance claims of their policy owners. Hence, it is also known as Claim Reserves.

Difference between Provision and Reserve

The following table highlights the major differences between Provision and Reserve −

ProvisionReserve
Provision records expenses incurred but payment yet to made. It is a means to provide for a future excepted loss/liability.Reserves are the funds that a company sets aside in order to invest in future projects.
It is showed on both sides of the balance sheet.It is showed on the liability side of the balance sheet.
It is not compulsory to generate profits in order to create Provisions.Companies that create Reserves must be profitable.
The availability of Provision is required in order to meet a probable loss in the future or an accruing liability.Companies create Reserves to strengthen their financial position
For business entities, it is mandatory to create provisions in their accounts.It is not mandatory to create Reserves.
The amount set as Provision can’t be used to invest outside business. Provisions are used for which they created.The amount set as Reserve can be used to invest outside business.

Conclusion

A Provision is an amount that is set aside to cover a probable future expenses. Note the word "probable" because these expenses have not been incurred yet. Balance Sheet Reserves, on the other hand, are surplus funds that a company sets aside to carry out its future projects

raja
Updated on 27-Jul-2022 09:42:53

Advertisements